The Profitability Premium: Macroeconomic Risks or Expectation Errors?

Macroeconomic risks only partially capture the relation between profitability and future stock returns, while an investor sentiment factor explains a substantial amount of the profitability premium. More importantly, the profitability premium only exists in firms whose market valuations are inconsistent with their profitability and therefore more subject to ex-ante expectation errors. We provide further evidence that firms with high profitability but low market valuation have significantly higher abnormal earnings announcement returns, analyst earnings forecast errors and forecast revisions than firms with low profitability but high market valuation. Moreover, the profitability premium only exists during high sentiment periods for firms with ex-ante expectation errors. Our results suggest that mispricing due to errors in expectation plays an important role in explaining the profitability premium.